The following information applies to the next three questions.

)
Magiclean Corporation is considering an acquisition of Dustvac Company. Dustvac has a capital
structure consisting of $5 million (market value) in 11% bonds and $10 million (market value) of
common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02 and both it and
Dustvac face a 40 percent tax rate. Magiclean's capital structure is 40 percent debt and 60
percent equity. The free cash flows and interest tax savings from Dustvac are estimated to be
$4.0 million for each of the next four years and a horizon value of $15.0 million in Year 4.
Additionally, new debt would be issued to finance the acquisition and retire the old debt, and this
new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0 percent and the
market risk premium is 4.0 percent.
WACC of target
i

What Dustvacs pre-merger WACC?

a. 9.02%
b. 9.50%
c. 9.83%
d. 10.01%
e. 11.29%

Discount rate for value of operations

ii

What discount rate should you use to discount the free cash flows and interest tax
savings?
a. 10.01%
b. 10.06%
c. 11.29%
d. 11.44%
e. 13.49%

Value of equity
iii

What is the value of Dustvacs equity to Magiclean? (Round your answer to the closest
thousand dollars.)
a. $17,019,000
b. $17,109,000
c. $17,916,000
d. $22,109,000
e. $22,916,000

WACC of target

Answer: c Diff: M

The pre merger weight on debt is 5/(5+10) = 0.333

The pre-merger required rate on equity is 6% + 1.36(4%) = 11.44%
WACC = wdrd(1-T) + wSrS = 0.333(11%)(1-0.40) + 0.667(11.44%) = 9.83%
ii

Discount rate for value of operations

Answer: c Diff: M

The correct discount rate is the unlevered cost of equity. The levered cost of
equity is 6% + 1.36(4%) = 11.44%, the percent of debt is 5/(5+10) = 0.333. The
rate on the debt is 11%
The unlevered cost of equity is wdrd + wersL = 0.333(11%) + 0.667(11.44%) =
11.29%
iii

Value of equity

Answer: b Diff: M

Time line: (In millions)

0 r=11.29% 1
|
|
PV = ?
4.0

2
|
4.0

3
|
4.0

4 Years
|
19.0

Financial calculator solution:

Inputs: CF0 = 0; CF1 = 4,000,000; Nj = 3; CF2 = 19,000,000; I = 11.29
Output: PVInflows = $22,109,662 = vops.
Value of equity = vops debt = 22.109 5 = $17.109 million.